Banking and the Laughable 'Money Multiplier' Myth

I recently listened to a podcast and part of the conversation included banking, money and credit. The host of the show was elaborating on how banks create money through the use of the "Money Multiplier" in a fractional reserve banking system like ours. Evidently, according to the host, bankers are somehow able to create money out of thin air by using this money multiplier.

Money out of thin air? This was starting to sound pretty good. It sounded so good that I wondered where I might get a magical money multiplier for myself! Can you imagine the fun you could have with a money multiplier? Then I remembered that banks don't create money. They lend money. They create credit.

But how about the money multiplier? Is it for real, or just one those economic terms people use to paper over the fact that they don't quite understand the different roles that banks and the Federal Reserve play in our monetary system? For those of you still wondering, it's the latter not the former. I've also noticed that quite a few economic writers labor under the impression that the VP at your local bank branch has a money maker. What puzzles me is that seemingly bright people have such difficulty understanding elementary accounting and balance sheet principles when it comes to money and credit. Money is money and credit is credit. They are not the same thing, they are completely different financial animals.

Banks don't create money. Only the Federal Reserve can create money. What you and I think of as money, the coins and paper that we carry in our pockets, is only one component of the money supply. Bank reserves on deposits at the Federal Reserve is the other component. Together they make up the Monetary Base and are sometimes referred to as Base Money, or the Money Supply. The Fed and only the FED can expand or contract the monetary base. This is done through open market transactions where the Fed purchases or sells interest bearing securities. If the Fed wishes to expand the monetary base it buys securities from the bank and credits the bank's reserve account at the Fed with newly created money in the form of reserves to pay for the transaction. The transaction has the effect of increasing the size of the Fed's balance sheet (it now owns more securities than before the transaction) and increasing the amount of base money (the bank now has more reserves on deposit with the FED) in the system.

If the Fed wants to contract the money supply it performs the opposite type of transaction. It sells securities (reducing the amount of securities the Fed holds on its balance sheet) to the bank from its portfolio, debiting (thus removing money from the bank's reserve account) the bank's reserves at the Fed for the securities sold to that bank. This shrinks the Fed's balance sheet and reduces the amount of base money in the system. By doing so the Fed can add or subtract reserves from the banking system, something that banks cannot do.

Unlike the banks in the old cowboy movies, today's financial institutions offer more than just a big old robber-proof vault to store your cash. Banks take money in, in the form of deposits, and lend out that very same money and a portion of its reserves to other banking customers in the form of loans. What has been created in these transactions is credit, which is not the same as creating money. No paper, coin or reserve money that didn't already exist is created when a bank makes a loan to a customer. Money that the bank has taken in on deposit and the bank's own reserves are used to make the loan. The money multiplier crowd's very simplistic argument is that when your local bank takes in your dollar bills and then lends out a portion of your dollar bills they have, through the magic of fractional reserve banking, created additional money. The money you deposited is right there in your checking account, and yet that other fellow with the big smile on his face, walking out of the bank, has a loan that was also made with your money courtesy of the magic of the money multiplier. Voila! But magic relies on showing you only what the magician wants you to see so that you can believe that what isn't real, is!

Let's pull back the curtain a little bit and turn up the house lights so we can see what's really going on. When you deposit your money into your checking account your deal with the bank is that they will hold that amount for you until you ask for it back, and then pay you the same amount, no questions asked, whenever you want. In the interim, there are a number of different options that the bank has in using your deposit. They can make loans, they can add to their reserves, and they can buy additional assets. When you are ready to make a withdrawal or cash a check they have to honor their promise to make your money available to you. The bank is liable to pay you back the amount you deposited, and that is exactly how it is recorded on their balance sheet as a liability, not as cash on hand.

Now if your bank intends to stick around for a period of time they'll need to earn a profit, and to do this they'll take the dollars that you deposited, less the reserve requirement, if any, which they hold in case a depositor wants some or all of their money back, and make an interest-bearing loan to another customer. This loan is recorded on their balance sheet as an asset. So, when you deposit $100 in your bank account the bank gives you a receipt for $100, and then it makes a loan for $95 while adding $5 to its reserves using the money deposited by you.

Were any additional dollars created here? No, the bank recorded a $100 liability on its balance sheet when it accepted your deposit and recorded a $100 asset when it made the $95 loan an added $5 to its reserve account. I don't see any magic or multiplication going on here. Do you?

So, I suppose the next question might be: Why would the Fed want to add to or subtract from the Money Supply? Let's save that for next time.